Visiting Scholar - Paul H. Nitze School of Advanced International Studies, Johns Hopkins University
European heads of state failed to agree on an economic plan to fight the coronavirus at their meeting last week. Action is vital. The hardest-hit states – Italy and Spain – cannot afford to fight the pandemic without aid from the rest of Europe. Yet the solutions they propose aren’t acceptable to the financially strongest European states – Germany, the Netherlands, Austria, and Finland.
The European Union’s leaders have given themselves until April 10th to come up with a workable plan. Here I propose a solution that meets the needs of the weak and satisfies the concerns of the strong.
Two divided camps
In preparation for the EU summit, a group of nine heads of state, including all the fiscally fragile ones, proposed eurobonds as the solution. Eurobonds would involve the mutualization of debt between states; richer states underwrite the debts of weaker ones. Eurobonds have been under discussion for years, but little progress has been made. The financially strongest countries continue to oppose them.
At the same time, Germany left the door open to use the European Stability Mechanism (ESM). The ESM is a European Union agency set up during the sovereign debt crisis to provide loans to countries in crisis. The trouble is that fiscally fragile member states have rejected the ESM in any of its available lending modalities. The most contentious issue is that ESM money comes with conditions designed to force recipient countries to make macroeconomic and structural reforms.
The European Central Bank has bought time for the politicians, keeping the crisis contained by injecting ample liquidity and fighting the widening of sovereign-spreads of Italy, Spain, and other fragile member states. The ball is now in the EU leaders’ court to come up with a plan that the ECB can also support. The key question remains: is there a solution that can work simultaneously for stronger and for weaker states?
A practical and workable plan involving the ESM and ECB
First, the richer countries need to abandon (almost) all ESM conditionality. Only one really is necessary: spend the ESM financial resources in well-targeted programs to sustain households and firms during the pandemic.
Second, make the ESM loans affordable for weaker member states. To this end, the ESM must charge zero or near zero spreads over its own cost of borrowing in the markets.
Third, the ESM available resources, EUR410bn, may need to be scaled up. But scaling up an existing facility is far easier than making a new facility fully operational from scratch when time is of the essence. Boosting the ESM’s capital would enable the ESM to increase its lending capacity by issuing more debt to the markets and the ECB.
Let’s assume that both richer and poorer member states agree on such a strategy. Would it work in practice? In other words, would such ESM support make public debt sustainable over the medium-term in the more fragile member states?
How it would work in practice
As detailed in a technical note published in Vox EU, using the example of Spain, my coauthors and I show that an ESM loan of 1) adequate size (at least 8 percent of GDP), 2) at zero spread to ESM’s funding rate, and 3) of 15-year maturity would deliver: a prudent path for Spain’s annual gross-financing-needs, a fiscal effort within reach, and sustainable public debt dynamics.
First, Spain would save over 12 percent of GDP in cumulative interest payments under ESM support relative to a scenario where Spain funds itself fully in the markets. Second, the annual fiscal effort required to put debt/GDP on a downward path would be similar to the pre-shock fiscal effort. And third, the annual gross financing needs for the state would stay at 19 percent of GDP, a level comparable to pre-crisis.
The ESM-based solution would also open the door to ECB’s Outright Monetary Transactions (OMT) to buy more government bonds of the country of up to 3-year maturities. This would work as a yield-curve control program applied to the front-end of the sovereign bond curve. In other words, the ECB could push sovereign-spreads tighter, funding costs lower, and improve public debt dynamics.
Overall, bold ESM financial support would achieve the objective of reinforcing debt sustainability in member states, including where it is needed the most. A combination of ESM funds, low ESM funding-rates, and ECB action would work. What we proposed is practical, speedy, and, last but not least, politically feasible.
The author did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. He is not currently an officer, director, or board member of any organization with a financial or political interest in this article.